The Risk-Return Continuum

By Schultz Collins Investment Counsel on September 28, 2022

The Risk-Return Continuum 

In our latest postings, we presented insights from one of our core documents: The Benefits of Diversification. Those postings examined how investors can try to reduce risk in their portfolios. These presentations can be viewed at our website: www.schultzcollins.com/resources. 

This article presents insights from another one of our core documents: The Risk-Return Continuum. It will explain some reasons why investors may want to increase risk in their portfolio. It will also discuss the trade-off between risk and return, how inflation affects risk and return, and what can happen to risk and return over longer time periods. 

To help us understand these insights, let’s consider the six different hypothetical portfolios in the chart below. The most conservative allocation, 100% bonds, is on the left and the most aggressive allocation, 100% stocks, is on the right. The allocation to stocks increases from left to right. 

Furthermore, the portfolios are diversified, with the bond portions divided into short-term and intermediate-term bonds. The stock portions have exposure to both domestic and international markets, as well as exposure to both small and large companies. US stocks also include a segment of value stocks, stocks that are cheaper based on certain financial ratios. 

These are the portfolios that are referenced through all the graphs and tables in this article. 

Data provided by Morningstar. For illustrative purposes only. 

Let’s start by looking at the historical interplay of risk and return for the six hypothetical portfolios from 1973 to 2021. The chart at the bottom of the page illustrates the data.  

If we focus only on the compound rate of return, marked by the columns in blue, we see returns rise as we go from left to right. We see the same pattern if we turn our attention to the green line, which represents the growth of a $1,000 invested since 1973 for each of these portfolios. Considering only these two data points, most investors are likely to want the most aggressive asset allocation since it provided the most return and ending wealth. All else being equal, why would an investor select a portfolio that would perform any less than the best? 

But all else is not equal. Each portfolio is exposed to different levels of risk because they hold different amounts of stocks and bonds. Let’s look at one particular measure of risk commonly cited by investment advisors: standard deviation. Standard deviation measures how volatile returns are. A low standard deviation indicates that returns tend to cluster closely around the average return, whereas a high standard deviation suggests that returns can be spread far from the average. Low standard deviation typically indicates less risk because investors are more likely to experience returns close to the average. Standard deviation is often used as one measure of risk, both for individual assets and entire portfolios of assets.  

Now let’s also consider the historical standard deviation of each portfolio, the red bars. As we go from left to right, standard deviation also rises. The chart as a whole tells us that investors need to take on more risk if they want more return.  

Data provided by Morningstar. For illustrative purposes only. 

So how can an investor gauge the amount of risk they are comfortable with? In addition to considering a portfolio’s stand deviation, an investor should consider how often their portfolio may lose value, and by how much.  

The table below graphically displays the number of quarters between January 1973 and December 2021. Each row represents a range that any quarter’s return may fall into. Near-zero returns are shown in the middle rows of the table with more extreme gains as one moves down, and more extreme losses as one up. The values in each row indicate the number of times each portfolio’s returns occurred in that range. For example, the 100% Fixed Income portfolio had 156 quarters with returns that ranged between 0% to 2%, and it had 36 quarters of returns between 2% and 4%. That portfolio had no returns outside those ranges, including no negative returns. 

The table shows that negative quarters occur more often as each portfolio becomes more aggressive. In exchange for the chance of higher returns associated with increasing allocations to stocks, an investor has to endure an ever-increasing range of possible outcomes in any given quarter. This is clearly illustrated by the fan-shaped pattern from left to right as one increases the percentage of a portfolio that’s invested in stocks.  

Despite the increasing risk, none of these portfolios experienced quarterly losses a majority of the time; in fact, each of the portfolios experienced quarterly gains at least 70% of the time. That equates to almost 34 years of positive quarterly growth out of a total of 48 years. Investors should consider how often gains and losses can occur in their investment decision process.  

Data provided by Morningstar. For illustrative purposes only. 

In addition to risk, an investor should also consider how inflation will affect a portfolio’s return.  

For the table below, don’t focus too much on the actual data points. Instead, focus on how many red numbers appear. Both sides display the annual returns for each of our hypothetical portfolios from 1982 through 2021. On the left-side are what we call the nominal returns, the returns that you see most commonly reported in the news, in shareholder reports, and in investors‘ account statements. They are what we’ve been talking about so far. They describe the absolute growth in a portfolio’s value.  

On the right-side are what we call the real, or inflation-adjusted, returns; these quantify the returns for each portfolio above and beyond the rate of inflation during each period. They describe the growth in a portfolio’s purchasing power, that is, how much the dollars in that portfolio can buy now versus how much they could buy before.  

Each of the red numbers is a negative return for that period. Do you notice any particular patterns for the data points in red?  

One pattern we see is that portfolios are riskier when we account for inflation. This phenomenon is particularly stark when comparing the nominal returns to the inflation-adjusted returns of the 100% Fixed Income portfolio. That portfolio has no negative returns on the left-side of the table but has many negative returns on the right-side. In exchange for greater certainty in the range of returns, an investor so allocated would have the greatest chance of losing purchasing power. Counterintuitively, the table shows that an investor may need to increase their allocation to stocks if they want to reduce the effect of inflation on their portfolio.  

Data provided by Morningstar. For illustrative purposes only. 

Now let’s look at what happens to returns when we consider time periods longer than a year. 

The table below looks similar to the previous table, but instead of annual returns, this tables show the returns for each hypothetical portfolio during overlapping three-year periods (e.g., 1980-1982, 1981-1983, etc.). Again, don’t focus too much on the actual data points. Instead, focus on how many red numbers appear.  

Do you see the same patterns as in the previous slide? What differences pop out between the red data points in this table compared to the previous one? 

Data provided by Morningstar. For illustrative purposes only. 

Notice that the three-year time period decreases the likelihood of experiencing negative returns. There are fewer red data points on this table compared to the previous one.  

Let’s look at another, longer time periods. Instead of annual returns or three-year returns, this table shows the returns for each hypothetical portfolio during overlapping five-year periods (e.g., 1978-1982, 1979-1983, etc.). 

Do you see some of the same patterns as in both previous slides? What differences pop out between the red data points in this table compared to the previous ones?  

There are fewer red data points on this final slide than we saw in the last two slides. What conclusion do we draw from this? While any one year could produce a negative return, probability favors the longer-term investor. These tables show that an investor may be more comfortable with risk if they are investing for the long-term.  

Data provided by Morningstar. For illustrative purposes only. 

There are many factors that investors should be aware of when constructing a portfolio, and this article only covered three of them. Investors may need to take on more risk if they desire greater return. They may also need to take on more risk if they want to mitigate inflation from eroding their portfolio. Investors may also be more comfortable with risk if they have long-term investment goals. We’ve only presented a few insights from our Risk-Return Continuum document, so please reach out to us if you’d like to learn more. Each investor is different, and we can help individuals determine which factors are important to them so they can make informed investment decisions.

As always, if you have questions about this information or any other subjects, please feel free to contact us at 415-291-3000.

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